Sunday, October 28, 2012

"conspiracy against public" requires Libor reform be based on banks providing ultra transparency

In his Guardian column, Larry Elliott looks at what has been proposed to reform Libor and concludes that much more needs to be done.

Regular readers know that what needs to be done is to reform Libor by requiring banks to provide ultra transparency and let the market use actual trade data to calculate the rate.

Your humble blogger submitted this suggestion to the Wheatley Review and their response was not only to ignore the suggestion, but to also exclude it from the responses on how to reform Libor that they published.

Mr. Elliott recognizes that the Libor reform solution proposed by Mr. Wheatley is woefully inadequate.

Adam Smith would be the perfect expert witness in the case being brought by Guardian Care Homes (nothing to do with this newspaper) against Barclays Bank, which has its first hearing in the high court on Monday. 
Way back in 1776, the sage of Kirkcaldy noted: "People of the same trade seldom meet together even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices."...
Libor is a strange creature, but the way it has been operated fits Smith's dictum to the letter.  
It is not like bank rate, set once a month by the Bank of England's monetary policy committee and which stands at 0.5%. Nor is it akin to the interest rate paid on the gilts the government issues to finance its debt, which is fixed at auction and established by the myriad daily trades in the bond market. 
Instead, Libor is set by a small number of big banks, who submit every day a rate at which they think they might be able to borrow rather than the rates at which they can actually borrow. After the highest and lowest submissions are trimmed, an average of the rest of the quotes becomes that day's Libor rate. 
Getting the right Libor rate matters. Banks should not be able to fiddle the rate to screw their customers. Nor should they be able to submit misleading quotes in order to disguise just how bad their financial position they are in....
The only way to achieve these three goals is to require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, banks with deposits to lend can assess the risk of the banks looking to borrow.  This ensures that the interbank lending market stays open.

With this information, market participants can calculate Libor off of actual trades.
The question, therefore, is whether it is sensible to leave such an important interest rate in the hands of a cabal of banks. Is it sufficient to put down the scandals exposed this year to a handful of rogue traders, poor internal management and inadequately policed regulatory safeguards, or is there a deeper malaise?
Clearly, the answer to these questions is no.

Since our markets are based on disclosure, the only sensible solution is disclosure in the form of ultra transparency.  Compare this to the complex rules and regulatory oversight that was proposed instead.
Enter poacher-turned-gamekeeper Alexis Stenfors, who received a five-year ban from working in the City after costing his employer Merrill Lynch $100m by concealing losses on his trading account. Stenfors is now an academic at the London School for Oriental and African Studies where he has just published two papers on Libor fixing. 
There will be those who say that, as a rogue trader himself, anything Stenfors says has to be taken with a pinch of salt. Yet, Stenfors was a trader for 15 years before his fall and he knows first-hand how the markets operate. 
Put simply, the argument in the papers – available at – is that there is a systemic problem with Libor. Although the banks would like us to believe that the scandal is down to a few bad apples, that is not the case. 
Nobody buys the few bad apples, because we keep finding out about other opaque areas of the banks that were also populated by a few bad apples (think CDOs, mis-selling of interest rate swaps,...).
The first paper analyses how banks have the means, the opportunities and the incentives to rig Libor in a way that is beneficial to themselves. They have the means because they collectively set the Libor rate. They have the opportunities because the Libor rates they submit have little or no bearing on the rates at which they actually trade.
Which is why all and not some subset of their trades need to be disclosed.
And they have two big incentives to "game" the rate. The first is that they can enhance the value of their own derivatives portfolios by manipulating Libor. The second is that they can avoid being stigmatised as a "bank in trouble" by putting in a low Libor rate that bears no relation to what they are actually paying for their finance.
In addition, we know the banks did this because Barclays confessed to manipulating Libor for these reasons and paid a fine.
In his paper, Stenfors conducts a number of different games, in some of which the banks collude with one another and in some of which they don't. In all the different scenarios, the outcome is a Libor rate that differs from the true funding costs of the banks. He also notes that the trimming process for removing the highest and lowest bids is ineffective and that bringing in new rules and constraints to enhance transparency provides disappointing results. 
Rules and constraints do not enhance transparency.  They are a substitute for transparency.

What enhances transparency is disclosure.  Specifically, ultra transparency. 
"Banks are given the chance to influence the Libor in a direction that is beneficial to them – stemming from the exclusive privilege to be able to play the game, in other words to participate in the Libor fixing process," he concludes....
Clearly, Libor fixing is a case where self-regulation has proved to be useless. This might not matter much if the potential costs of getting Libor wrong were minor. But they are not: they are potentially astronomic, ....
the government has said it will accept the findings of Martin Wheatley's report into Libor, published last month, in full. These include statutory regulation, making misleading Libor quotations a criminal offence and giving the FSA powers to force participating banks to abide by a new code of conduct. 
But if Stenfors is right and Libor is structurally flawed, these reforms will not be enough. This "conspiracy against the public" requires ... an entirely new system.
A system based on requiring the banks to provide ultra transparency.  A system that the UK regulators already rejected in favor of complex rules and regulatory oversight.

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